Question

Andrew sees a classified ad from Beth offering a used smartphone for $15. On the opposite page, he sees a big color as from a national electrinics chain offering a new smartphone for $300. Andrew values a smartphone at $335 as long as it works, regardless of whether it is new or used.

For each of the scenarios listed, determine the principle illustrated by each person's reasoning.

Scenario Moral Hazard Adverse Selection

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Suppose Andrew buys the new smartphone from the national electronics chain,

thinking, "Someone would ask $15 for a used smartphone only if it didn't work well."

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Suppose Beth, the seller of the smartphone, knows the phone works well-she is selling it

only because she got a better model as a gift. She thinks about asking $50 and offering

a guarantee: She will replace the smartphone with a new $300 smartphone if it turns

out not to work. Then she thinks, "That's not a good idea! Someone can just buy it,

handle it carelessly, and, if it breaks, can pretend it didn't work and get a new smartphone

for $50-meanwhile, I would be out $250!"

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Why is Beth unable to sell Andrew the smartphone? Check all that apply.

A. Adverse selection can cause buyers to avoid purchsing high-quality goods because of the uncertainty about their quality.

B. Moral hazard can prevent sellers from offering guarantees of quality because they can't be sure that buyers won't try to take advantage of the guarantees by filing false claims.

Please: Answer the questions directly and clearly. Often times, people reply with very long answers and it makes it very confusing to understand which are the correct answers. If you can make a chart kind of like the one I made above and if you can put an check mark to say whether it is Moral Hazard or Adverse Selection, that would be apprecited. Or say, for scenario 1 it so and so and for scenario 2 it is so and so. The last question is multiple choice. Please answer clearly whether A or B is correct or both A and B is correct.

Answer 1

Suppose Andrew buys the new smartphone from the national electronics chain, thinking, "Someone would ask $15 for a used smartphone only if it didn't work well."
Ans. A

Explanation
This would be adverse selection because Andrew is not sure about the quality of the product. The buyer does not have complete information about the product.

Suppose Beth, the seller of the smartphone, knows the phone works well-she is selling it

only because she got a better model as a gift. She thinks about asking $50 and offering

a guarantee: She will replace the smartphone with a new $300 smartphone if it turns

out not to work. Then she thinks, "That's not a good idea! Someone can just buy it,

handle it carelessly, and, if it breaks, can pretend it didn't work and get a new smartphone

for $50-meanwhile, I would be out $250!"

Ans. B

Explanation

This woudl be an example of moral hazard because Beth does not have complete information about the buyer's behaviour. The buyer has incentive to increase the risk.